FSLY - Fastly Inc. (FSLY) Presents at KeyBanc Technology Leadership Forum 2023 (Transcript)
2023-08-07 20:22:02 ET
Fastly, Inc. (FSLY)
KeyBanc Technology Leadership Forum 2023
August 7, 2023 4:30 PM ET
Company Participants
Vernon Essi - IR
Ron Kisling - CFO
Conference Call Participants
Tom Blakey - KeyBanc Capital Markets
Presentation
Tom Blakey
My name is Tom Blakey. For those who don't know, I'm the Infrastructure Technology and Software Analyst here at KeyBanc. And I'm grateful to have the CFO here, Ron Kisling; and the Head of Investor Relations, Vernon Essi.
Just kicking it right off, you guys had a great quarter. Stock acted very positively to such news. It's accelerated growth.
Question-and-Answer Session
Q - Tom Blakey
Just want to kind of maybe let you highlight any other features of the quarter that maybe I'm missing in addition to that accelerated growth.
Ron Kisling
And I think, we typically -- Q1 to Q2 typically tends to be flat. We did see a little bit of acceleration in Q2. We had one of our larger customers consolidated their CDN providers down from 5 to 2 in the first quarter. And subsequent to that, we have seen really good traffic growth from that customer. And we continue to see really good traffic growth in the commerce space going through Q2 that drove some of that Q1 to Q2 acceleration.
Tom Blakey
And let's talk about the sustainability of that. I mean, you mentioned that this cut into some of the seasonality. Maybe talk about the seasonality going into the second half. Obviously, fourth quarter is seasonally strong. We saw an uptick in large customers -- as a percentage of revenue from large customers. I just want to kind of understand your -- is visibility increasing, staying the same, decreasing?
Ron Kisling
Yes. I think, the overall market in terms of sort of sales cycle has been fairly stable over the last six to 12 months. We haven't seen any material changes there. I think, going into the second half, that certainly as we move through the year, our visibility increases, and we continue to see really good traction in the market. If you look at sort of the key dynamics, one of the key dynamics is just customer acquisition. And one of our goals is to accelerate customer acquisition, and we have been doing a lot of initiatives really to sort of drive that go-to-market effort. We did a reorganization of the sales team at the beginning of the year to make that organization much more efficient by aligning the account executives, the account management, the support and sales engineers into the same pod, so they are working together with the same customers, reducing some of the friction in that organization. I'm sure we will talk a little bit more. But we have launched packages, which are three set recurring revenue items that are already structured to sell into the market that also reduce friction in the sales cycle. All of which are designed to drive-up the productivity, increase new customer acquisition, where we then see really good extension within those as demonstrated by our LTM NRR, which in most recent quarter was 116%. And as we see more and more customer acquisition, there is an opportunity to grow that number.
Tom Blakey
From a macro perspective, you mentioned traffic. In addition to that, consolidating traffic on your platform increased. I think you mentioned that traffic also increased as I understand. The CDN market, there's some large players there that are growing. Maybe they are losing share or not. But just what do you see the CDN market growing at and where your share gains there at?
Ron Kisling
I think if you look at and we shared this at Investor Day, I think, broadly speaking, we sort of see the CDN market I think mostly growing at around 8%. What we have really seen over the last couple of years is, really gaining market share in that market. And so we have seen our growth more kind of in the mid to high teens in terms of the growth rate on our CDN space. And what we've seen driving that really is a combination of performance, both in terms of being able to win business by driving lower latency, very easy to manage. We have extremely efficient caching and purging. Particularly as you sort of see the market begin to be focused on cost management, they're looking at what are my costs to support this network? Very easy to manage. What are the costs, my ingress and egress costs? And we're very efficient by our managing caching to lower those costs and driving higher performance. And so all those metrics have really resonated in terms of us continuing to gain market share.
Tom Blakey
You talked about product and packaging. Is that a driver of market share gain? Like in that 5 to 2 example, you talked about the downsizing or the consolidating spend from a large CDN customer, or is this helping with more new logos or both?
Ron Kisling
I think it's helping more with new logos. It's largely to reduce some of the friction by offering a delivery package that has all the components that you need. If you want to deploy delivery to a customer at a fixed recurring rate, it's not a bespoke contract. I think one of the things that we've seen as we've rolled this out that it's really resonated with people, is having this predictable cost structure. We offer these a delivery package, a security package, and a compute package. And particularly in compute, which is a fairly new offering and customers are trying to figure out where to use it and how to deploy it. When we launched the package with fixed price, we saw a significant increase in the number of customers who began to start to use it and experiment with it.
And we found that one of the barriers was, it's a new product. I don't know what the uptake is going to be, and so I don't know what it's going to cost. And so we found predictability is really resonating with customers and it's going to, one, reduce the sales cycle. So it's going to increase the productivity of our sales team, but it's also an opportunity to make it much easier to sell into the mid-market where our bespoke consumption-based contracts are much more challenging to sell. It has an added benefit that as we leverage our partner network that we currently use across our security business, is that by having a delivery package, they're also able to expand our capabilities by selling delivery.
Tom Blakey
You mentioned one of those packages of security. It's about, I think 14% of revenue in 2Q '23. Let's talk about like the -- like you said, the product and packaging changes in security and the growth they're in. And then I'd like to hear more about the roadmap of services that you'd like to expand, basically the offering that you are bringing to your customers.
Ron Kisling
Yes. So if you look at our security portfolio, we really are focused around web application security, the security that web application developers are using. In Q2, as you mentioned, our Signal Sciences was 14% of revenue. We have other security offerings. And while we don't break out the total security piece, that's going to be in the mid to high teens as a percent of revenue. Our security offerings and we're really focused on developing, is really across our web application firewall that we acquired from Signal Sciences. It's an industry leading firewall. More customers run it in blocking mode than any other product. And it now has full feature parity running on our platform as it does in the non-platform version.
On DDoS, we've had in our delivery DDoS protection, but we haven't productized -- productizing that with visibility to customers reporting, visibility to what those traffic stats are. So they have visibility if they need to take other actions, and that is one of the goals for this year.
And then the third leg of that stool is really bot protection, where we're developing a protection -- a bot protection product to help our customers, particularly those in commerce, make sure that the products they're selling are going to legitimate customers rather than brokers who are using bots. We've launched the beta on that, and both of these are planned for this year delivery. And so, our security package would include WAF, web application firewall, DDoS, bot protection, and API protection.
Tom Blakey
And the DDoS environment you said is more on the horizon. What is additive to say in 2Q '23? So it's mid to high teams. What are the security services does Fastly offer?
Ron Kisling
So, in addition to -- so the security services broadly, as I spoke about is across WAF, DDoS, which we again offer today.
Tom Blakey
Today?
Ron Kisling
Today, yes. And then the bot protection will be coming later this year.
Tom Blakey
Maybe just switching gears to everybody's favorite topic on AI. I think we talked about a little bit on the call, but just maybe summarize for us, what, if at all gen AI as a catalyst for Fastly in terms of the increased usage, the increased need for performance of the content and the like, and what kind of timing would you expect that to start impacting the top line growth of your company?
Ron Kisling
Yes. I mean, I do think, ultimately, it's a driver to me. It is another expanded driver around what the compute capabilities are. It's about engaging web experiences, moving from the level of personalization we have today to more high-fidelity personalization or experiences on the web. I think customers are beginning to experiment with AI. Today, I think it's probably we'll start to see revenue, I would say probably 12, 15 months. I think as you get to the end of 2024, I think we'll start to see customers deploying it as we go through a period of experimentation. And then with growth from that.
Tom Blakey
And this would drive your -- the content.
Ron Kisling
It would drive, I think it would drive really the compute business primarily. And I think it's another opportunity as you really look at the opportunity with our platform to drive growth and expansion, it's a cross sell opportunity that can accelerate our cross-sell motion.
Tom Blakey
You mentioned that your -- I think it was your Analyst Day in June, like symbiotic relationship with the hyperscalers. You guys are focused on the edge and there are other edge providers that are trying to build out their own core provider services. Can you kind of maybe update us on your relationship or give us a review of your relationship with public clouds and hyperscalers, and maybe even from a channel perspective, the way you guys are working together, generating business?
Ron Kisling
Yes. So I think, we work very closely, I think with the hyperscalers. I think if you look at kind of the delivery there is a need for that central cloud, central compute. It's an efficient way to store. It doesn't make sense to store that globally, but in terms of actually deploying that to users around the world at an edge platform is the strategy. And we work very closely with them. We participate in the AWS marketplace as a channel to sell. And we really see as an opportunity for us being able to deliver to the edge this information efficiently.
Tom Blakey
Is -- am I characterizing it correctly that there could be a relationship where you're helping drive business stairway in terms of storage or compute, and you are obviously in the need of some of the unique attributes of an edge network vis-a-vis like regulatory -- geolocation-related regulatory. Is there -- or is that, is that in the multi-set currently in the business model today, like in terms of related revenues?
Ron Kisling
Yes. And there certainly have been instances with customers where we bring an opportunity to them. They bring an opportunity to us. I'd say, it's a small piece of the business, but we do engage in opportunities from time-to-time in terms of being able to really deliver a solution to the customer that provides a fast, engaging and safe experience at the edge, utilizing immersive data.
Tom Blakey
I mean, I will just need to ask for me. Is there any questions from the audience? No. Keep going. Maybe this is an opportunity to switch to the model. I think we commented or I commented earlier that you guys are just maybe in the more immediate term, increased your percentage of revenues from large customers. And there could be no relation at all, but you have also guided gross margins down versus consensus that I think even relative to your prior guide. I mean, walk us through any kind of near-term just temporal movements there in the gross margin and if at all, you would expect gross margin, overall on the delivery side as you got to target more of large customers?
Ron Kisling
I mean, I think if you look globally, our gross margin accretion in the value proposition and efficient in the network is intact. What we -- it is not a linear progression. In the first quarter, as I talked about, we had a large customer who consolidated their CDNs. We gained a lot of traffic from that, which you saw in our Q2 revenues. A lot of that traffic was in regions where we had very small presence. And so given that small presence, a lot of our cost structure was relatively high. The good news is, is with the higher traffic, we are able to go back into those regions, negotiate much better pricing on our bandwidth because we now bring much more better volume. But there is a short-term impact where we go through that process of renegotiating those contracts. The benefit, though, we continue to drive traffic through our network is with this higher traffic and these lower bandwidth costs, that benefits all the traffic in those regions, not just this new customer. So while it may be a short-term, the medium to long-term gross margin trajectory is intact.
Tom Blakey
Along those lines, you guys are definitely best-in-class in terms of the percentage of revenue you spend on CapEx. So it's not -- like, I'm just talking about near-term movements here. And the so longer-term, how low could that go? I mean -- and I assume these kind of numbers in terms of percentage of spend on CapEx has embedded in your longer term goals. I think your 2026 target is around 65% gross margins.
Ron Kisling
Yes.
Tom Blakey
Is the current kind of mid to high 50s currently? Does CapEx need to stay at that level or go lower to meet those targets in CapEx, given the sovereign nature of your network go lower?
Ron Kisling
I think in the medium-term, which is where we have visibility, I think you have that 6% to 8% range as a sustainable level. That's down to almost half of what it was 2.5 years ago when we were 12% to 14%. So I think it's a sustainable number. I think, beyond that, I think it's probably too early to tell whether there is future benefit beyond that. Certainly as we expand geographically with some of these larger customers, there is an element of expansion baked into that 6% to 8%.
Tom Blakey
I was going to ask a follow-up. I mean, Fastly spoke to some iteration of new CEO in September of last year and talked about productive action. But the turning down of some business, small businesses and making sure the infrastructure spend is more optimized. From a strategic perspective along those lines, trying to encapsulate all that, is Fastly in the mindset of moving -- of turning away business in concept of making sure that CapEx stays at this level?
Ron Kisling
As I indicated, that 68% does incorporate expansion on a geographic basis. I don't think we've been in a position where we've had to turn down business. And I think, the overall efficiency of our network, it allows us to compete very effectively with the other competitors in the market and still generate really good gross margins.
Tom Blakey
It's important to the -- because we get a lot of like from investors too, and I'm sure you do in your private conversations. On the notion of just splitting it out by guidance, but I think I've heard commentary from material calls that, you believe that the CDN margins could even go upwards of 60% irrespective of the higher margin value added services. Is that accurate? And is that encapsulated in the 68% as a percent of revenue?
Ron Kisling
I think, that's accurate and in the midterm 2026 outlook that reflects our view on kind of the overall mix of traffic.
Vernon Essi
Yes. I think very, I'd be remiss not to say though, if you look at our investor presentation for our Investor Day in June, we have a slide in there that talks about how we were able to drive more efficiency with the software upgrade on the same server fleet in North America. And it drove a 29% year-over-year improvement, quarter-on-quarter without a nickel of extra hardware spend. So, I mean, obviously that's a flash point in time, but it demonstrates what our platform's capable of.
Tom Blakey
Is that replicable? Because that was going to my next question, I wasn't going to ask about the 29%. I missed, I forgot that slide. Just as important -- this is the software opposed to maybe others that would build longer.
Ron Kisling
Yes. The engineering team I know is specifically working on a number of additional engineering updates that would have meaningful improvements in the efficiency of the hardware when they roll it out. And as Vern shared, I mean, this is -- one of the benefits is we can roll out this patch and it's equivalent to getting deploying 29% more hardware with simply a software patch.
Tom Blakey
So, switching off -- the, I think…
Ron Kisling
I'm getting used to it.
Tom Blakey
…you talked about the channel helping from a customer acquisition perspective. Talk to me about where you are in terms of you and your channel today, where you expect it to be in the future. And I'm always interested in what the drivers are, channels need to be incented. It's pretty relatively straightforward business and what would be the incentives for the channel to work with you?
Ron Kisling
Yes, well, I think first and foremost, I think, the good news is we have a really I think mature channel motion, particularly around our security products. We acquired Signal Sciences, they had a large channel presence. We maintain that. We have a sales channel organization that supports the channel today. And so this isn't a spin up of the infrastructure to support it. What we're able to do with a delivery package is give our channel partners something else to sell. And a lot of times we see very high attach rate between our web application firewall and our delivery. And so this gives them another product to sell.
Particularly as you look at just the efficiency of overall sales organization, this is an opportunity to really expand that reach, to reach into that mid-market and accelerate new customer acquisitions by having not only our sales team adding to our customer base, but a whole set of channel partners going out and selling delivery. And I think there's a unique piece, which is -- I think we're unique in this space in terms of utilizing the channel to sell delivery.
Tom Blakey
Right. And you are -- and I'm just wondering again -- well first of all, as an adjunct to that, where are you in that building that base of sell delivery? And again, what does the business model quite frankly look like for the channel partners in terms of sell delivery?
Ron Kisling
Yes. I would say where we are -- we launched this earlier this year. We've seen very successful deal reg in those customers. And I would anticipate we will start to see delivery sales and be able to see the success of it, as we get into late this year. And I believe it'll be a meaningful contributor to new customer acquisition in delivery in 2024.
Tom Blakey
And how's the model, how does it work in terms of the channel? How do they get paid on this and how recurring is that?
Ron Kisling
I mean there is a -- margin works very similar to how it works with the security model today. And that they resell the security at a margin. And this works very similar to that with the same incentives in place that they have on security models. So it's a well worked model. They're familiar with it. It’s they're not having to learn something new.
Tom Blakey
You mentioned it's unique in terms of the delivery side. Why do you think that hadn't been taken up by others?
Ron Kisling
It's a good question. I know for us, we were selling a largely consumption-based business with bespoke contracts, which was a barrier to being able to sell through the channel. As we rolled out these packages, it makes it very easy. So I think for us, it was -- the barrier historically was a way of selling. Not really sure, kind of more broadly. I think it's a perfect fit, particularly kind of in the space that our channel partners work. And it is a great opportunity also to just sell across the platform, because they're very big on security and a lot of times these two go together.
Tom Blakey
Perfect sense. And just pause one more time for the audience.
Unidentified Analyst
I'm just curious. How far out do customers lock any minimum contracts? I'm just kind trying to think visibility that you have. Is it awesome? Is it -- can it massively move up and down throughout the quarter?
Ron Kisling
I think…
Vernon Essi
Could you repeat the question?
Ron Kisling
Yes, repeat. The question was -- go ahead.
Unidentified Analyst
Just the visibility of revenue in terms of how far out your contracts go?
Ron Kisling
Yes. So I think, today the big biggest piece of our business is consumption based contracts. Typically, they're on a 12 month basis. Some of them do have commits. One of the things we have talked about is that one of the challenges is the predictability of the business, or the volatility being consumption based. We certainly see a lot of seasonality based on traffic patterns and that's a factor of the seasonality. Over time I think we've continued to develop closer and closer relationships and communication with our largest customers to get better visibility from market. But with these packages, as we sell more of these, as security becomes a bigger piece of revenue, which is sold on a recurring revenue basis, this is going to give us more predictability and more visibility to our revenue than we have today.
Tom Blakey
And my final question would just be from the CFO's perspective, the go-to market we've talked about something unique is the hyperscalers and this great opportunity to build out the channel here maybe impact even numbers sooner than later. But what about internally? I mean, what is the kind of like plan to build out the go-to-market infrastructure? And now that you've kind of re-productized, repackaged a lot of the portfolio, where do you think you need to make additive investments there or maybe not at all?
Ron Kisling
Yes. I mean, I think there is really two areas. I think we are going to continue to invest in direct quota carrying sales reps to drive that. We have just brought on a new Chief Marketing Officer and so it's lead development and marketing are going to be an adjunct to that to drive more leads into the sales organization. A lot of the focus this past year has really been around trying to drive up the efficiency of our sales organization through pricing and packaging, through organization of that team, and we are working on systems as well really to drive efficiency. I think the other thing I would have when you start to just look at -- I pay a lot of attention to margins and cash flow is that, we put a lot of focus on financial rigor, eliminating duplicate SaaS systems, really creating a robust purchasing function, so that we have been able to actually drive a much more efficient business, able to make some of these incremental investments out of those savings rather than driving incremental savings. And so this year, we have been able to add our quota carrying sales reps. We have been able to make investments in marketing, and yet we are still driving leverage in our operating expenses, growing those at a lower rate than revenue, bringing down our operating loss from 18% of revenue last year to 9% this year at the midpoint of our guidance that we just shared on the last call. So it's all of this working together to be able to make those investments in the areas that accelerate growth.
Tom Blakey
Thank you very much for your time, Ron and Vern. Thank you very much.
Ron Kisling
Thank you.
Vernon Essi
Yes.
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Fastly, Inc. (FSLY) Presents at KeyBanc Technology Leadership Forum 2023 (Transcript)